14
Chapter Fourteen
Business Unit
Performance
Measurement
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
L.O.1 Evaluate divisional accounting income as a performance measure.
L.O.2 Interpret and use return on investment (ROI).
L.O.3 Interpret and use residual income (RI).
L.O.4 Interpret and use economic value added (EVA).
L.O.5 Explain how historical cost and net book value–based accounting
measures can be misleading in evaluating performance.
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Tomorrow I have to recommend to the board of directors the regional manager who I believe did the best
job last year. The board wants to begin thinking about
grooming a successor for me as my retirement nears.
My problem is that I need to be able to show the board
evidence about why one manager gets my vote over
the others. There are a lot of intangibles, and I can explain those. What the board will want to see is some
evidence of performance that members can use to
evaluate managers they know less well.
I know that Best Buy (the electronics retailer)
looks at Economic Value Added ®, but I wonder
whether that is too complicated for our operation.
Perhaps a simple measure, such as return on investment (ROI) might be sufficient.
Simon Chen, CEO of Mustang Fashions, a national
chain of western wear stores, was discussing his problem
with Rebecca Stuart from Garcia & Stuart, a local management consulting firm. Stuart has been working with Mustang
Fashions to develop a performance evaluation and compensation plan for corporate and regional executives. The effect
of applying the different evaluation systems and the implications for how individual managers will fare under each have
been identified, but the consulting team is not yet ready with
its recommendation. Once he has the team’s recommendation, Chen will use it to decide on a measure (or measures)
to present to the board.
We described the organization of the firm in Chapter 12 by referring to responsibility
centers: cost centers, profit centers, and investment centers. The advantage of this classification is that it describes the delegation of decision authority and suggests the appropriate performance measures. For example, because cost center managers have authority
to make decisions primarily affecting costs, an appropriate performance measure is one
that focuses on costs.
Divisional Performance Measurement
In this chapter, we develop and analyze performance measures for investment centers or business units. The distinguishing feature of business unit managers is that they have responsibility
for asset deployment, at least to some extent, in addition to revenue and cost responsibility. We
will refer in our discussion to business units as divisions—a common term for an investment
center—but the concepts and methods we discuss here are appropriate for any organizational
unit for which the manager has responsibility for revenues, costs, and investment.
As we develop performance measures, our discussion will be guided by three considerations.
• Is the performance measure consistent with the decision authority of the manager?
• Does the measure reflect the results of those actions that improve the performance of
the organization?
• What actions might managers be taking that improve reported performance but are
actually detrimental to organizational performance?
What Determines Whether Firms Use Divisional Measures
for Measuring Divisional Performance?
In this chapter, we focus on divisional measures of performance for divisional managers. However, it is common practice among firms to include firm measures as well. What
determines whether firms rely on other information? One
study found that divisional measures are more important when
the division’s accounting measure correlates highly with the
In Action
relevant industry’s price-earnings ratio. The role of divisional
measures decreased with the extent to which the manager’s
decisions affected the performance of other divisions.
Source: A. Scott Keating, “Determinants of Divisional Performance
Evaluation Practices,” Journal of Accounting and Economics 23
(no. 3): 243–273.
515
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The last question is particularly important for the designer of performance measurement
systems. No performance measurement system perfectly aligns the manager’s and organization’s interests. Therefore, the systems designer has to be aware of possibly dysfunctional decisions that managers might make.
Accounting Income
L.O. 1
Evaluate divisional
accounting income as a
performance measure.
divisional income
Divisional revenues
minus divisional costs.
Because divisions have both revenue and cost responsibility, an obvious performance
measure is accounting income (divisional income). Investors use accounting income to
assess the performance of the firm, so it is natural for the firm to consider the division’s
income when assessing divisional performance. Furthermore, divisional income serves
as a useful summary measure of performance by equally weighting the division’s performance on revenue and cost activities. Divisional income is simply divisional revenues
minus divisional costs.
Computing Divisional Income
The computation of divisional income follows that of accounting income in general. Remember, however, that because divisional income statements are internal performance
measures, they are not subject to compliance with generally accepted accounting principles (GAAP). Firms might choose to use firmwide averages for some accounts or ignore
other accounts (taxes, for example).
See Exhibit 14.1 for the divisional income statements for Mustang Fashions for year 1.
We observe in the exhibit that Mustang Fashions is organized into two divisions based on
geography, Western and Eastern. Many firms organize into geographical responsibility
units. Another common basis for organization is product line.
The managers of Mustang Fashions’ two divisions have responsibility for sales (revenues), costs (including purchasing and operating costs), and some investment decisions.
Specifically, the company’s division managers are responsible for choosing store location
and lease terms, credit and payables policy, and store equipment. Mustang Fashions’s central staff provides support for legal and financial services. Thus, the company’s division
managers are investment center (business unit) managers.
In reviewing Exhibit 14.1, we see that the after-tax income (profit) was $336,000 and
$214,200 in the Western and Eastern divisions, respectively. Based on after-tax income as
the performance measure, we would conclude that the manager of the Western Division
performed better than the manager of the Eastern Division.
Exhibit 14.1
Division Income
Statements—Mustang
Fashions
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
lan27114_ch14_514-547.indd 516
C
B
MUSTANG FASHIONS
Divisional Income Statements
For the Year 1
($ 000)
Western
Eastern
Division
Division
Sales
Costs of sales
Gross margin
Allocated corporate overhead
Local advertising
Other general and admin
Operating income
Tax expense (@ 30%)
After-tax income
$ 5,200.0
2,802.0
$ 2,398.0
468.0
1,200.0
250.0
$ 480.0
144.0
$ 336.0
$ 2,800.0
1,515.0
$ 1,285.0
252.0
500.0
227.0
$ 306.0
91.8
$ 214.2
D
Total
$ 8,000.0
4,317.0
$ 3,683.0
720.0
1,700.0
477.0
$ 786.0
235.8
$ 550.2
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517
Advantages and Disadvantages of Divisional Income
There are several advantages to using after-tax income as a performance measure. First,
it is easy to understand because it is financial accounting income computed in the same
way that income for the firm is computed. Second, it reflects the results of decisions under the division manager’s control. Third, it summarizes the results of decisions affecting
revenues and costs. Finally, it makes comparison of divisions easy because they use the
same measure, dollars of income.
There are two important disadvantages to using divisional income as a performance
measure, however. First, although the results of the Eastern and Western divisions can be
compared, it is not clear that the comparison reflects only the performance of the managers.
One obvious problem is that the divisions may be of different sizes. That is, if the Western
Division is much larger, it should be easier for its manager to report higher income.
The second disadvantage is that the measure does not fully reflect the manager’s
decision authority. In the case of Mustang Fashions, the managers have responsibility for
investment (assets), but other than depreciation expense, the effects of asset decisions
are not reflected in the division’s performance measure. This results in an inconsistency
between decision authority and performance measurement. From the discussion in Chapter 12, we know that when such an inconsistency exists, the management control system
might be ineffective.
Some Simple Financial Ratios
One approach to correcting the first problem—that the divisions are different sizes and,
therefore, difficult to compare—is to use financial ratios. Because we have information
only on income, we are limited (for the moment) in the ratios we can compute. However,
we can use the three profitability ratios in Exhibit 14.2 to see how well the two divisions
performed.
The gross margin ratio reflects the performance of the manager regarding sales and
the cost of goods sold. The gross margin ratio is the gross margin (sales minus cost of
goods sold) divided by sales. Using the gross margin ratio as the performance measure,
Exhibit 14.2 indicates that the manager of the Western Division performed better than the
manager of the Eastern Division. However, the gross margin ratio ignores costs other than
the cost of goods sold.
A more comprehensive performance measure is the operating margin ratio, which
is the operating income divided by sales. This measure includes the effect of not only the
cost of goods sold but also operating costs. We see in Exhibit 14.2 that, based on operating margin as the performance measure, the manager of the Eastern Division performed
better than the manager of the Western Division.
A third ratio is the profit margin ratio, which is after-tax income divided by sales.
This measure includes the effect of divisional activities on taxes. In this case, with the
same tax rate, the relative performance of the two divisions remains the same; the Eastern
Division shows better performance.
These three ratios are only examples of how we could adjust divisional income for
size differences. The important issue is that none of these adjustments addresses the second disadvantage of divisional income, the omission of asset usage in the performance
measure.
A
1
2
3
4
5
6
lan27114_ch14_514-547.indd 517
Ratio
Gross margin percentage
Operating margin
Profit margin
B
Definition
(Gross margin Sales)
(Operating income Sales)
(After-tax income Sales)
C
Western
Division
46.12%
9.23
6.46
D
Eastern
Division
45.89%
10.93
7.65
gross margin ratio
Gross margin divided by
sales.
operating margin ratio
Operating income divided by
sales.
profit margin ratio
After-tax income divided by
sales.
Exhibit 14.2
Selected Financial
Ratios—Mustang
Fashions
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Self-Study Question
1.
Home Furnishings, Inc., is a nationwide retailer of home
furnishings. It is organized into two divisions, Kitchen
Products and Bath Products. Selected information on
performance for year 2 follows:
a.
b.
Compute after-tax divisional income for the two divisions. The tax rate is 35 percent. Comment on the
results.
Using the information from requirement (a), assess
the relative performance of the two division managers at Home Furnishings, Inc.
Kitchen
Bath
($000)
Revenue . . . . . . . . . . . . . . . . . . .
Cost of sales . . . . . . . . . . . . . . . .
Allocated corporate overhead . . .
Local advertising . . . . . . . . . . . . .
Other general and admin. . . . . . . .
$10,000
5,400
460
2,000
500
$5,000
3,000
200
500
260
The solution to this question is at the end of the chapter on
pages 545–546.
Return on Investment
L.O. 2
Interpret and use return
on investment (ROI).
return on investment
(ROI)
Ratio of profits to investment
in the asset that generates
those profits.
Exhibit 14.3
Division Balance
Sheets—Mustang
Fashions
lan27114_ch14_514-547.indd 518
If managers have responsibility for asset acquisition, usage, and disposal, an effective
performance measure must include the effect of assets. One of the most common performance measures for divisional managers is return on investment (ROI), which is
computed as follows:
After-tax income
ROI ______________
Divisional assets
Later in this chapter, we discuss some of the choices associated with computing income
and assets, but for now, we will use very simple calculations for these accounting and
investment measures (profits and assets).
See Exhibit 14.3 for the divisional balance sheets for Mustang Fashions. Notice that
although Mustang Fashions wholly owns the two divisions, the company prepares balance
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
Assets
Cash
Accounts receivable
Inventory
Total current assets
Fixed assets (net)
Total assets
Liabilities and Equities
Accounts payable
Other current liabilities
Total current liabilities
Long-term debt
Total liabilities
Total shareholders’ equity
Total liabilities and equities
B
MUSTANG FASHIONS
Balance Sheets
January 1, Year 1
($ 000)
Western
Division
$ 250
225
250
$ 725
775
$ 1,500
$
125
227
$ 352
–0–
$ 352
1,148
$ 1,500
C
Eastern
Division
$ 150
250
150
$ 550
350
$ 900
$
95
280
$ 375
–0–
$ 375
525
$ 900
D
Total
$ 400
475
400
$ 1,275
1,125
$ 2,400
$
220
507
$ 727
–0–
$ 727
1,673
$ 2,400
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A
1
2
3
4
5
6
7
After-tax income from income statement, Exhibit 14.1 ($ 000)
Divisional investment from balance sheet, Exhibit 14.3 ($ 000)
ROI ( After-tax income Divisional investment)
B
Western
Division
$ 336.0
1,500.0
C
Eastern
Division
$ 214.2
900.0
22%
24%
519
Exhibit 14.4
ROI for Western and
Eastern Divisions—
Mustang Fashions
sheets as if the divisions were separate entities. This is not important for our development
of performance measures, but we include it to show that the measures presented here
apply to investment centers that could be separate legal entities, such as subsidiaries.
Based on the information in Exhibit 14.1 and Exhibit 14.3, we can compute the ROI
for the two divisions at Mustang Fashions (see Exhibit 14.4). It is important to remember
that there is a large volume of literature on the “correct” way to compute financial ratios. It
is not our purpose here to discuss and critique these differences, although we will discuss
some of the basic issues involved in computing income and investment later in this chapter.
Instead, we focus on the general issue of ratio-based performance measures, such as ROI.
The computation of ROI in Exhibit 14.4 is based on beginning-of-the-year investment (the balance sheet is dated January 1). This is how Mustang Fashions defines ROI.
Later in this chapter, we discuss the use of the beginning-of-the-year, end-of-year, and
average investment as the base for the ROI calculation.
Performance Measures for Control: A Short Detour
The focus in this chapter is on performance measurement, but before we evaluate ROI as
a performance measure, we illustrate the role it can play in control. That is, we can use
information from ROI to highlight the areas of the business that require attention.
Suppose that Western Division’s ROI has been declining over time. We would like
information that indicates where the problem could be. One approach is to decompose
ROI into two or more ratios, which, when multiplied, equal ROI.
After-tax income
ROI ______________
Divisional assets
Sales
After-tax income
______________ ______________
Sales
Divisional assets
Profit margin ratio Asset turnover
The managers at Mustang Fashions and its divisions can now determine whether the
decline in ROI is due to declining profit margins, which might suggest the need to implement cost controls, or to lower asset turnover, which might suggest the need to review asset
utilization (evaluating inventory levels, for example). By decomposing the ratio, managers can
anticipate where problems will occur in achieving acceptable ROIs and can take action early.
The profit margin ratio is a measure of the investment center’s ability to control its
costs for a given level of revenues. The lower the costs required to generate a dollar of
revenue, the higher the profit margin. The asset turnover ratio is a measure of the investment center’s ability to generate sales for each dollar of assets invested in the center.
Relating profits to capital investment is an intuitively appealing concept. Capital is a
scarce resource. If one unit of a company shows a low return, the capital could be better
employed in another unit where the return is higher, invested elsewhere, or paid to stockholders. Relating profits to investment also provides a scale for measuring performance.
Limitations of ROI
Although ROI is a commonly used performance measure, it has two limitations. First, the
many difficulties in measuring profits affect the numerator, and problems in measuring
the investment base affect the denominator. Consequently, making precise comparisons
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among investment centers is difficult. Because accounting results are necessarily based
on historical information, these numbers tend to focus on current activities, which makes
the measures myopic.
More important, however, is that the use of ROI can, at least conceptually, give incentives to managers that lead to lower organizational performance. Thus, using ROI can
lead the manager to make suboptimal decisions.
Short-Term Focus (Myopia) from Accounting Information What do we
want managers in the divisions of a firm to do? We want them to take steps that, among
other things, will increase the organization’s value. Ideally, we would measure performance
based on the change in the value of the firm that results from the managers’ actions.
The problem we face is that we cannot directly measure this value, especially for
business units in the organization. The division is not publicly traded, so we cannot look
at how investors assess managers’ actions. We must use accounting information, which
is an imperfect reflection of the change in value. Accounting measures suffer from three
general problems.
First, accounting income—the numerator in ROI—is “backward looking.” That is, it
reflects what has happened but does not include all changes in value that may happen as a
result of the decisions that managers make. For example, a decision today to buy a new plant
would not necessarily result in increased sales this period but may lead to increased sales next
period. By dividing the activities of the firm into periods of a year, accounting information
omits many of the benefits (and some of the costs) of actions in a particular year.
A second, related problem is the accounting treatment of certain expenditures, especially expenditures on intangible assets such as research and development (R&D), advertising, and leases. Although these expenditures are made by managers who believe that
these expenditures will have long-term returns, accounting conventions often result in
recording the entire expenditure as an expense in the period it is made.
Finally, while accounting treatment for intangibles often results in early recognition
of the costs, but not the benefits, it also treats many sunk costs as providing benefits in the
future. This is true of expenditures for plant assets, for example, which are depreciated over
the life of the asset and might not be written off even after the asset is no longer used.
As we will see in the following discussion, each of these three problems can be addressed by developing a particular performance measure specifically designed for a given
situation. However, for most firms, one advantage of using ROI is that the information
needed to compute it already exists in the accounting records.
Conflicting Incentives for Managers (Suboptimization) A more serious
problem with ratio-based measures is that a manager can make decisions that lower organizational performance but increase the manager’s reported performance. We illustrate this
with an example.
Sergio Correlli is the manager of Mustang Fashions’ Western Division. Sergio’s assistant
has presented him an analysis that outlines the benefits of a new type of display rack (see
Exhibit 14.5).1 The new racks require less maintenance, so the benefits consist of the cash
savings in maintenance. The racks will last three years and will be depreciated over that period using straight-line depreciation, which is used throughout the company. Sergio’s performance is measured on the basis of ROI. He is expected to meet his target of 20 percent return
on investment, which is the same as Mustang Fashions’ after-tax cost of capital.
If Sergio’s performance measure is ROI, he will be concerned with the impact of the
new investment opportunity on this measure. See Exhibit 14.6 for the calculation of ROI
for the proposed investment. Notice that the ROI changes each year, but in the first year,
the ROI is less than the level the company expected of Sergio.
As a performance measure, ROI is not consistent with the investment analysis. The net
present value of the investment in the display racks is positive, which means that the firm
The analysis in Exhibit 14.5 assumes that you are familiar with present values and the basics of capital budgeting. We present a review of this material in the appendix to the book.
1
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521
Exhibit 14.5 Present Value Analysis: Display Equipment, Western Division—Mustang Fashions
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
A
Investment
Annual cash flow
Economic life of the investment
Annual depreciation
Increase in operating income
Income tax rate
Increase in income tax
Cost of capital
B
C
$ 480,000
270,000
3
160,000
110,000
30%
33,000
20%
D
Initial outlay, year
End of year
End of year
End of year
Net present value
0
1
2
3
F
G
(assumed to be received at the end of each year)
years
( Investment Economic life of the investment)
( Annual cash flow Annual depreciation)
( Increase in operating income Income tax rate)
Before-tax
Cash Flow
$ (480,000)
270,000
270,000
270,000
Initial outlay
End of year 1
End of year 2
End of year 3
E
Income Tax
(@ 30%)
–0–
$ 33,000
33,000
33,000
Present Value Analysis
Present
Value
Factor
1
0.833333
0.694444
0.578703
After-tax
Cash Flow
$ (480,000)
237,000
237,000
237,000
Present
Value
(@ 20%)
$ (480,000)
197,500
164,583
137,153
$ 19,236
Cash
Flow
$ (480,000)
237,000
237,000
237,000
Exhibit 14.6 ROI Calculations, Western Division—Mustang Fashions
A
1
2
3
4
5
6
7
8
9
10
B
Year
1
2
3
C
Cash Flow
$ 270,000
270,000
270,000
D
Depreciation
$ 160,000
160,000
160,000
E
Before-Tax
Income
$ 110,000
110,000
110,000
F
Income Tax
(@ 30%)
$ 33,000
33,000
33,000
G
After-Tax
Income
$ 77,000
77,000
77,000
H
Beginning of
Year Net
Investment
(Net of
Accumulated
Depreciation)
$ 480,000
320,000
160,000
I
ROI
(After-Tax
Income Beginning of
Year Net
Investment)
16%
24
48
will benefit from acquiring the racks. However, the performance measure signals the manager that it is not a good investment because the ROI (at least for the first year) is less than
the required rate of return. As a result, ROI does not provide a signal that is consistent with
the decision criterion used for the investment.
There is a second, related way in which ROI can lead to suboptimization by the manager. Suppose, for example, that the ROI expected next year in the Western Division is
25 percent and in the Eastern Division it is 10 percent. When the two division managers
evaluate the same decision (whether to buy the display racks), they could make different
decisions. Sergio, the manager of the Western Division, will compare the ROI of the investment to his expected ROI. The ROI of the investment is less than the expected ROI,
so he has an incentive not to make the investment.
Kyoko Murakami, the manager of the Eastern Division, has a different incentive.
Because Eastern Division’s expected ROI is below the 16 percent ROI for the display
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With ROI as a performance measure,
managers have incentives to forgo
investment in new plant and equipment in
order to keep the asset base low, often
below the optimal level.
racks, Kyoko has an incentive to make the investment. Thus, using ROI
as the performance measure leads to a situation in which the division
performing more poorly, based on ROI, has the incentive to adopt more
projects.
If the manager adopts the new project, the ROI of the division will
be the weighted average of the ROI of the project and the ROI of the
division without the project. The weights are the relative investments in
the new project and the division’s performance prior to the project. This
means that any project with an ROI below that of the division without the
project will lower the division’s reported performance. A manager compensated on annual ROI performance might choose not to adopt a project
that increases firm value.
Both myopia and suboptimization are problems with ROI as a performance measure. We next discuss alternatives to ROI that some companies have adopted. We note, however, that many companies continue
to use ROI. It is important to understand that in our identification of
these limitations, the manager looked at the effect on ROI of his or her
decision and reacted only to the result. The environment of performance
measurement is much richer. Corporate managers, who were once division managers, understand these incentives and watch for certain behavior. Division managers are motivated by a complex mix of compensation,
reputation, loyalty to the firm, and an understanding of what is “right.” In
identifying these limitations, we simply note that the potential for managers having incentives to take actions that are not in the organization’s
interest exists and that the designer of the management control system
must be aware of these potentially dysfunctional incentives.
Self-Study Question
2.
Consider the case of Home Furnishings, Inc., which was
described in Self-Study Question 1. Divisional assets
are $8,200,000 in Kitchen Products and $4,000,000 in
Bath Products.
a. Compute ROI for the two divisions.
b. Assess the relative performance of the two division
managers at Home Furnishings, Inc., using ROI.
The solution to this question is at the end of the chapter on
page 546.
Residual Income Measures
L.O. 3
Interpret and use
residual income (RI).
cost of capital
Opportunity cost of the
resources (equity and debt
capital) invested in the
business.
cost of invested capital
Cost of capital multiplied by
assets invested.
residual income (RI)
Excess of actual profit over
the cost of invested capital
in the unit.
lan27114_ch14_514-547.indd 522
One of the problems we identified with divisional income as a business unit performance
measure is that it does not explicitly consider the investment usage by the unit. The reason is that accounting income is designed to report the return to the owners of the organization and then let them compare the return to their cost of capital. One approach to
incorporate investment usage, which we just described, divides income by investment.
A second approach is to modify divisional income by subtracting the cost of invested
capital (the cost of capital multiplied by the division’s assets, which measures the investment in the division) from accounting income.
Specifically, we define residual income (RI) as
Residual income After-tax income (Cost of capital Divisional assets)
In other words, residual income is the divisional income less the cost of the investment
required to operate the division. The cost of capital is the payment required to finance
projects. The computation of the cost of capital is a subject for finance courses. In this
book, we take it as given. Residual income is similar to the economist’s notion of profit
as being the amount left over after all costs, including the cost of the capital employed in
the business unit, are subtracted.
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523
Exhibit 14.7 Residual Income for Western and Eastern Divisions—Mustang Fashions
B
A
1
2
3
4
5
6
7
8
C
D
After-tax income from income statement, Exhibit 14.1 ($ 000)
Divisional investment from balance sheet, Exhibit 14.3 ($ 000)
Cost of capital
Cost of invested capital ( Cost of capital Divisional investment)
Residual income
E
Eastern
Division
Western
Division
$ 336.0
$ 214.2
$ 900.0
20%
$ 1,500.0
20%
300.0
$ 36.0
180.0
$ 34.2
The residual income for the Western Division of Mustang Fashions is computed assuming a cost of capital of 20 percent (see Exhibit 14.7). The $36,000 residual income
in the Western Division can be interpreted as follows. The operations (the manager) in
the Western Division earned $36,000 for Mustang Fashions after covering the cost of
the merchandise, the operations, and the cost of the capital that has been invested in the
Western Division.
One advantage of residual income over ROI is that it is not a ratio. Managers evaluated using residual income invest only in projects that increase residual income. Therefore, there is no incentive for managers in divisions with low residual incomes to invest
in projects with negative residual incomes. The reason is that the residual income for the
division is the sum, not the weighted average, of the residual income for the project and
the residual income for the division prior to the investment in the project.
Limitations of Residual Income
Residual income does not eliminate the suboptimization problem. See Exhibit 14.8 for
an analysis of the investment in display cases, assuming that residual income is the performance measure. Again, there is a conflict between the decision criterion, net present
value, and the performance measure, residual income. The project has a positive net present value but a negative residual income in year 1. However, residual income reduces the
suboptimization problem. As Exhibit 14.8 illustrates, the present value of the residual income is equal to the net present value of the project. Therefore, if the manager considers
the impact of the investment on residual income over the life of the project, the incentives
of the manager and the incentives of the firm will be aligned. In addition, if residual income for the year is positive, the manager has an incentive to invest in the project regardless of the division’s residual income prior to the investment.
One approach to reducing the problem of managerial myopia, the distortion in
incentives that results from problems with accounting measures, is to modify divisional
income so that it better reflects economic performance. Such an approach is the idea
behind economic value added (EVA).
Exhibit 14.8 Residual Income for the Acquisition of Display Cases, Western Division—Mustang
Fashions ($000)
A
1
2
3
4
5
6
7
8
9
10
11
lan27114_ch14_514-547.indd 523
B
Year
1
2
3
C
After-Tax
Income
$ 77,000
77,000
77,000
D
Beginning of
Year Net
Investment
(Net of
Accumulated
Depreciation)
$ 480,000
320,000
160,000
E
F
Residual
Income
Cost of
(After-Tax
Invested
Income Capital
Cost of
(@ 20%)
Invested Capital
$ 96,000
$ (19,000)
64,000
13,000
32,000
45,000
Present value of residual income
G
H
Present
Value
Present Value
(@ 20%)
Factor
0.833333
$ (15,833)
0.694444
9,028
0.578703
26,042
$ 19,236
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Management Control Systems
Economic Value Added (EVA)
Although the concept of residual income has a well-established history in economics,
few firms have adopted it as a performance measure.2 More recently, a concept closely
Interpret and
related to residual income, called economic value added (EVA), has received attention as
use economic value
a performance measure for business units, and has been adopted by companies such as
added (EVA).
Coca-Cola, Herman Miller, and Diageo.
Economic value added (EVA® ) makes adjustments to after-tax income and capieconomic value
tal to “eliminate accounting distortions.”3 The “accounting distortions” commonly
added (EVA)
adjusted are the treatment of inventory costs, the expensing of many intangibles, and
Annual after-tax (adjusted)
so on. For example, pharmaceutical firms, such as Glaxo, invest heavily in research
divisional income minus the
and development (R&D). Generally Accepted Accounting Principles (GAAP) in the
total annual cost of (adjusted)
United States require firms to expense R&D. Firms invest in R&D, however, because
capital.
they believe that the expenditure of funds today will result in benefits (returns) in the
future. Treating R&D as an expense when
managers are evaluated using accounting
income–based measures can reduce their
willingness to invest in R&D. One solution is to capitalize the expenditure and
amortize it over the economic life of the
project. Of course, accounting principles
change (International Financial Reporting Standards or IFRS, for example) and
these might reflect better the economics
of the transactions.
The capital employed is also adjusted
for these same accounting treatments. If,
for example, R&D is capitalized, the portion of its expenditures not included in
income is recorded on the balance sheet
and represents additional investment in
the business unit. A second adjustment to
capital that is typically made is to deduct
Generally Accepted Accounting Principles (GAAP) require expensing R&D,
such as costs for research into new pharmaceuticals. Using EVA, managers can
current liabilities that do not represent debt
design a performance measure that eliminates this accounting “distortion.”
from the calculation of capital. Many current liabilities, for example accounts payable, do not carry explicit costs of capital; any
capital cost is included in the acquisition cost and, ultimately, in cost of goods sold.
Thus, advocates of EVA argue that accounting income measures (and the capital
employed) need to be adjusted for these distortions in order to compute an appropriate
measure of performance. We illustrate the computation and use of EVA with Mustang
Fashions. We caution you that many implementations of EVA differ in the details of the
computation. In this book, we take a very simple approach to the calculation in order to
illustrate the concept.
We assume that only one accounting treatment—of advertising—requires adjustment. Advertising expenditures at Mustang Fashions have been expensed in the year
incurred, but management believes that the favorable brand image resulting from the
advertising campaign will have a two-year life. In other words, expenditures on advertising are the same as any expenditure on an asset that has a two-year life. Last year
(year 0), Western Division recorded $800,000 in advertising expenditures and Eastern
L.O. 4
An exception is the use of the residual income concept by General Electric in the 1960s. In fact, according to David Solomons, “The General Electric Company has given the name residual income to this
quantity” [the excess of net earnings over the cost of capital]. See Divisional Performance (Homewood,
IL: Irwin, 1965): 63.
3
G. Bennett Stewart III, The Quest for Value (New York: HarperBusiness, 1991): 90.
2
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EVA at Best Buy
In Action
Best Buy, the electronics retailer, uses activity-based costing
to support its use of EVA as a financial performance measure.
Currently, EVA is reported at an aggregate level with limited
distribution. Measuring EVA at Best Buy requires accounting
decisions such as how to allocate corporate, retail opera-
tions, and logistics costs. Supporting EVA, the company uses
an activity-based costing system and activity-based management approaches to improve corporate value.
Source: http://www.imanet.org/research_costing_reading.asp#5
Division spent $300,000. We also assume—for simplicity—that last year was the first
in which Mustang Fashions made advertising expenditures.
See Exhibit 14.9 for the computation of EVA for Mustang Fashions. Several comments about these computations are in order.
1. The after-tax income is used, but the tax expense is not adjusted for the adjustment
to advertising expenditures. The tax implications of advertising are not affected by
their treatment for performance measurement purposes. To provide a useful signal
for management decision making, we want to include actual taxes because they will
be computed based on the expenditures (the decision choice by managers).
2. Current liabilities are deducted from divisional investment.
Exhibit 14.9 EVA for Western and Eastern Divisions—Mustang Fashions Year 1 ($000)
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
C
B
D
Western
Division
$ 336.0
1,200.0
$ 1,536.0
After-tax income from income statement, Exhibit 14.1
Add back advertising expense, Exhibit 14.1
Less amortization of advertising (see amortization table below)
Advertising expenditure in Year 0 (@ 50% of the $ 800,000 expenditure in Year 0)
Advertising expenditure in Year 1 (@ 25% of the $ 1,200,000 expenditure in Year 1)
Adjusted income
$ 400.0
300.0
$
Divisional investment, Exhibit 14.3
Less current liabilities, Exhibit 14.3
Net Investment
Unamortized advertising, beginning of year (see amortization table below)
Advertising expenditure in Year 0 [@ (1–25%) of the $ 800,000 expenditure in Year 0]
Adjusted divisional investment
Calculation of EVA:
Adjusted income (from above)
Cost of adjusted divisional investment (@ 20%)
EVA
Amortization of advertising expenditures:
Expenditures Made in Year
0
1
2
lan27114_ch14_514-547.indd 525
$ 150.0
125.0
$ 900.0
375.0
$ 525.0
600.0
$ 1,748.0
225.0
$ 750.0
$
$ 439.2
150.0
$ 289.2
836.0
349.6
486.4
Amortization Rate in Year
1
2
25%
0
0
275.0
$ 439.2
$ 1,500.0
352.0
$ 1,148.0
$
0
700.0
836.0
E
Eastern
Division
$ 214.2
500.0
$ 714.2
50%
25%
0
25%
50%
25%
4
0%
25%
50%
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Management Control Systems
3. We have assumed that advertising expenditures are made uniformly throughout the year.
Therefore, 50 percent ( 1 year 2-year life) of the advertising expenditures made
last year are expensed this year. Only 25 percent of the expenditures made this year are
expensed, because we assume that advertising expenditures are made uniformly over
the year. A general amortization schedule is shown at the bottom of Exhibit 14.9.
These computations appear complicated, but they are exactly the same as those you would
make if the accountant mistakenly recorded the entire cost of a machine as an expense instead
of properly recording it as an asset and then depreciating it over its useful life. In the case of
Mustang Fashions, the accountant recorded advertising as an expense, as required by GAAP,
but the economics of the transaction require a correction to record it as an asset.
Limitations of EVA
Conceptually, EVA addresses many of the problems associated with ROI and residual
income. It is not a ratio, so managers invest in projects as long as EVA is positive. It corrects for many of the accounting distortions that make the other measures myopic. While
we have illustrated how to adjust for advertising expenditures, the same approach can be
used for any accounting convention that distorts performance.
The difficulty is that EVA replaces one accounting system for another. In the Mustang
Fashions illustration, we determined that it was inappropriate to expense advertising costs
as they were incurred. Instead, we amortized those costs over a two-year period because we
made the assumption that advertising outlays would benefit the firm for two years.
This illustrates some of the implementation problems with EVA. Who determines the
appropriate life for the advertising expenditures? The division managers could be in the
best position to do this, but they are being evaluated using the result. Should the same life
be used in both regions? These questions can be answered, but it is unlikely that there will
be full agreement among the managers.
EVA also does not resolve the suboptimization problem (see Self-Study Question 3).
The fundamental problem is that EVA is based on accounting income while the decision
to invest is based on the present value of cash flows.
In Action
Does Using Residual Income as a Performance Measure
Affect Managers’ Decisions?
There is very little systematic evidence on whether using
residual income measures such as EVA for evaluating business unit managers affects decision making. One study,
which is based on data from 40 firms, suggests that firms
that have adopted residual income measures
•
•
Reduced new investment and had greater asset dispositions.
Engaged in more payouts to shareholders through
share repurchases.
•
Had more intensive asset utilization.
It is important to document the effect of performance measures on decision making because if the measures do not
influence decisions, they cannot affect firm performance.
Source: James Wallace, “Adopting Residual Income-Based
Compensation Plans: Do You Get What You Pay For?” Journal of
Accounting and Economics 24 (no. 3): 275–300.
Self-Study Question
3.
Suppose that Mustang Fashions uses EVA as the performance measure for divisional managers. Will the
manager of either division (Eastern or Western) want to
invest in the display racks? Why?
lan27114_ch14_514-547.indd 526
The solution to this question is at the end of the chapter on
page 546.
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Divisional Performance Measurement: A Summary
The four performance measures we have described (divisional income, ROI, residual income, and EVA) are all used, to a greater or lesser extent, by corporations around the
world. This suggests that all four measures have their strengths and limitations. We have
described these strengths and limitations here. All accounting-based performance measures will have limitations because of the inherent problem of measuring economic performance, including future opportunities and costs, with accounting systems that rely on
observed (past) transactions.
As managers and accountants, it is important that you understand these strengths and
limitations. This will allow you to choose the best performance measure given the business environment and strategy of your organization.
Measuring the Investment Base
Effective business unit performance assessment requires a measurement of divisional
assets. We have discussed some accounting issues associated with measuring both income and investment in the development of EVA. In addition to the adjustments we
have described, three general issues are frequently raised in measuring investment bases:
(1) Should gross book value be used? (2) Should investment in assets be valued at historical cost or current value? (3) Should investment be measured at the beginning or at
the end of the year? Although no method is inherently right or wrong, some can have
advantages over others. Furthermore, it is important to understand how the measure of the
investment base will affect ROI, residual income, and EVA. We illustrate these methods
assuming that ROI is used for performance measurement, although the same comments
will apply to the residual income measures, including EVA.
L.O. 5
Explain how historical
cost and net book
value–based
accounting measures
can be misleading in
evaluating performance.
Gross Book Value versus Net Book Value
Suppose that a company uses straight-line depreciation for a physical asset with a
10-year life and no salvage value. The reported cost (expense) of the asset does not
change; it is the same in year 3 as in year 1. See Exhibit 14.10 for a comparison of ROI
under net book value and gross book value for the first three years. For simplicity, we
assume that all operating profits before depreciation are earned at the end of the year,
ROI is based on the year-end value of the investment, and there are no taxes.
Note that the ROI increases each year under the net book value method even though
no operating changes take place. This occurs because the numerator remains constant
while the denominator decreases each year as depreciation accumulates.
Historical Cost versus Current Cost
The previous example assumed no inflation. Working with the same facts, assume that the
current replacement cost of the asset increases about 20 percent per year, as do operating
cash flows. See Exhibit 14.11 for a comparison of ROI under the original or historical cost
and the current cost, what it would cost to acquire the asset today.
Note that ROI increases each year under the historical cost method even though no
operating changes take place. This occurs because the numerator is measured in current dollars to reflect current cash transactions while the denominator and depreciation
charges are based on historical cost. The current cost methods reduce the effect by adjusting both the depreciation in the numerator and the investment base in the denominator
to reflect price changes. Measuring current costs can be a difficult and expensive task,
however, so there is a trade-off in the choice of performance measures.
We derived a level ROI in the current cost, gross book value method because the asset and all other prices increased at the same rate. If inflation affecting cash flows in the
numerator increases faster than the current cost of the asset in the denominator, ROI will
lan27114_ch14_514-547.indd 527
historical cost
Original cost to purchase or
build an asset.
current cost
Cost to replace or rebuild an
existing asset.
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Part IV
Exhibit 14.10
Management Control Systems
Facts
Impact of Net Book Value
versus Gross Book Value
Methods on ROI
Amounts in thousands of dollars.
Profits before depreciation (all in cash flows at end of year): year 1, $100; year 2,
$100; and year 3, $100.
Asset cost at beginning of year 1, $500. The only asset is depreciable, with a
10-year life and no salvage value. Straight-line depreciation is used at the rate of
10% per year. The denominator in the ROI calculations is based on end-of-year
asset values.
Year
1. . . .
Net Book Value
$100a (.1 $500)b
ROI _________________
$500d (.1 $500)e
2. . . .
$50 $450
$100 (.1 $500)
ROI ________________
$450 (.1 $500)
3. . . .
Gross Book Value
$50 $400
$100 (.1 $500)
ROI ________________
$400 (.1 $500)
$50 $350
ROI
11.1%
ROI
12.5%
ROI
14.3%
$50c
____
$500
10%
$50
____
$500
10%
$50
____
$500
10%
a
The first term in the numerator is the annual cash profit.
The second term in the numerator is depreciation for the year.
c
Net income $50 $100 ($500 .1). Companies sometimes use only cash flows in the numerator.
d
The first term in the denominator is the beginning-of-the-year value of the assets used in the investment
base.
e
The second term in the denominator reduces the beginning-of-year value of the asset by the amount of
current year’s depreciation.
b
increase over the years until asset replacement under the current cost method. Of course,
ROI will decrease over the years until asset replacement if the denominator increases
faster than the numerator does.
Although current cost might seem to be a superior measure of ROI, recall that there
is no single right or wrong measure. Surveys of corporate practice show that the vast
majority of companies with investment centers use historical cost net book value. In a
number of cases, many assets in the denominator are current assets that are not subject to
distortions from changes in prices.
In general, how a performance measure is used is more important than how it is
calculated. All of the measures we have presented can offer useful information. As long
as the measurement method is understood, it can enhance performance evaluation.
Beginning, Ending, or Average Balance
An additional problem arises in measuring the investment base for performance evaluation. Should the base be the beginning, ending, or average balance? Using the beginning
balance could encourage asset acquisitions early in the year to increase income for the
entire year. Asset dispositions would be encouraged at the end of the year to reduce the investment base for next year. If end-of-year balances are used, similar incentives to manipulate purchases and dispositions exist. Average investments would tend to minimize this
problem, although computing average investments could be more difficult. In choosing
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Chapter 14
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529
Exhibit 14.11
Facts
Amounts in thousands of dollars.
Operating profits before depreciation (all in cash flows at end of year): year 1, $100;
year 2, $120; and year 3, $144.
Annual rate of price changes is 20 percent.
Asset cost at beginning of year 1 is $500. At the end of year 1, the asset would
cost $600; at the end of year 2, it would cost $720; and at the end of year 3,
it would cost $864. The only asset is depreciable with a 10-year life and no
salvage value.
Straight-line depreciation is used; the straight-line rate is 10 percent per year. The
denominator in the ROI computation is based on end-of-year asset value for this
illustration.
Impact of Net Book Value
versus Gross Book Value
Methods on ROI
Net Book Valuea
Year
1. .
Historical Cost
$100 (.1 $500)
ROI ________________
$500 (.1 $500)
2. .
$50 $450
ROI 11.1%
_____
_____
$120 (.1 $500)
ROI ________________
$500 (.2 $500)
3. .
Current Costb
$70 $400
$144 (.1 $500)
ROI ________________
$500 (.3 $500)
$94 $350
ROI 17.5%
_____
_____
$40 $540
_____
7.4%
$120 (.1 $720)
________________
$720 (.2 $720)
ROI 26.9%
_____
_____
$100 (.1 $600)
________________
$600 (.1 $600)
$48 $576
_____
8.3%
_____
$144 (.1 $864)
________________
$864 (.3 $864)
$57.6 $604.8
_____
9.5%
_____
Gross Book Value
Historical Cost
1. .
2. .
3. .
ROI $100 $50
__________
$50 $500
ROI $120 $50
__________
$70 $500
ROI $144 $50
__________
$94 $500
Current Costb
$500
$100 $60
__________
$40 $600
ROI $120 $72
__________
$48 $720
10%
$500
$500
ROI 14%
ROI 18.8%
$600
6.7%
$720
6.7%
$144 $86.4
____________
$864
$57.6 $864
6.7%
a
The first term in the numerator is the annual profit before depreciation.
The second term in the numerator is depreciation for the year.
The first term in the denominator is the beginning-of-the-first-year value of the assets used in the
investment base.
The second term in the denominator reduces the beginning-of-year value of the asset by the amount
of accumulated depreciation: By 10 percent for accumulated depreciation at the end of year 1, by
20 percent at the end of year 2, and by 30 percent at the end of year 3.
b
Operating income is assumed to exclude any holding gains or losses.
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Management Control Systems
an investment base, management must balance the costs of the additional computations
required for average investment against the potential negative consequences of using the
beginning or ending balances.
Self-Study Question
4.
Winter Division of Seasons, Inc., acquired depreciable
assets costing $4 million. The cash flows from these
assets for three years were as follows:
Year
Cash Flow
1 ....................
2 ....................
3 ....................
$1,000,000
1,200,000
1,420,000
Depreciation of these assets was 10 percent per year;
the assets have no salvage value after 10 years. The
denominator in the ROI calculation is based on end-ofyear asset values. If replaced with identical new assets,
these assets would cost $5,000,000 at the end of year 1,
$6,250,000 at the end of year 2, and $7,800,000 at the
end of year 3.
Compute the ROI for each year under each of the
following methods (ignore holding gains and losses):
a. Historical cost, net book value.
b. Current cost, net book value.
c. Historical cost, gross book value.
d. Current cost, gross book value.
The solution to this question is at the end of the chapter on
page 547.
Other Issues in Divisional Performance Measurement
Divisional income, ROI, residual income, and EVA are financial performance measures
that consider the activities of the business unit independently of other units in the firm.
Business units are a part of the firm, not separate businesses, because something—
products, research activities, markets, and so on—keeps them together. Measuring the
manager only on the division’s results risks suboptimal decision making because the manager ignores the effect of the decisions on other business units.
In Chapter 15, we discuss how transfer prices can help the performance measurement
of business units by signaling the value of the good or service being exchanged between
units to each of the business unit managers. Nonfinancial measures of performance, including subjective measures, are described in Chapter 18.
The Debrief
Simon Chen, CEO of Mustang Fashions, looked at the consultant’s report summarizing the strengths and limitations of
the performance measures that might be used to evaluate
managers in Mustang’s two divisions. He commented:
After reading the report, I realize that this is a very
important decision because it will affect how my
managers make decisions. Although it would be
nice if someone would just say that measure “x” is
the best measure (and I know there are those who
would), I also know that it is not that simple.
lan27114_ch14_514-547.indd 530
For our business at this time, I think I will use
a simple version of EVA with only one or two adjustments. The most important thing I take from this
is that this will be a decision I will need to reconsider routinely to ensure that, first, EVA is helping
us make good decisions without being too complex
and, second, we do not rely solely on this one measure. As I said earlier, there are a lot of intangibles
I consider and I do not want a single financial measure to become our sole focus.
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531
Summary
Business unit performance measures rely on information from the accounting system, especially measurements of unit income and unit investment. Return on investment, residual income, and EVA are
measures that explicitly include the investment in the unit. These measures correct for some of the
problems of using accounting income as a measure. However, because they are based on accounting
income, they do not completely align the interest of the manager with the interest of the organization.
The following summarizes key ideas tied to the chapter’s learning objectives.
L.O. 1. Evaluate divisional accounting income as a performance measure. Divisional income
provides one measure that is consistent with the firm’s profit goal, but it ignores the
capital invested in the unit.
L.O. 2. Interpret and use return on investment (ROI). ROI is the ratio of profits to investment
in the asset that generates those profits. This measure facilitates comparisons among
units of different sizes. Because it is a ratio, managers might not invest in projects that
are profitable for the firm.
L.O. 3. Interpret and use residual income (RI). Residual income is the difference between
profits and the cost of the assets that generate those profits. Because it is not a ratio,
managers will invest as long as the residual income in the project is positive, regardless
of what residual income currently is.
L.O. 4. Interpret and use economic value added (EVA). EVA is a variation of residual
income that adjusts income to better reflect the economics underlying certain transactions, such as investment in R&D.
L.O. 5. Explain how historical cost and net book value–based accounting measures can be
misleading in evaluating performance. Both of these measures can be misleading in
evaluating performance. Investment center managers have an incentive to postpone
replacing old assets using these measures.
Key Terms
cost of capital, 522
cost of invested capital, 522
current cost, 527
divisional income, 516
economic value added (EVA), 524
gross margin ratio, 517
historical cost, 527
operating margin ratio, 517
profit margin ratio, 517
residual income (RI), 522
return on investment (ROI), 518
Review Questions
14-1.
14-2.
14-3.
14-4.
14-5.
14-6.
14-7.
14-8.
What are the advantages of divisional income as a business unit performance measure? What
are the disadvantages?
How is divisional income like income computed for the firm? How is it different?
What are the advantages of using an ROI-type measure rather than the absolute value of
division profits as a performance evaluation technique for business units?
Give an example in which the use of ROI measures might lead the manager to make a decision that is not in the firm’s interests.
How does residual income differ from ROI?
How does EVA differ from residual income?
What impact does the use of gross book value or net book value in the investment base
have on the computation of ROI?
What are the dangers of using only business unit measures to evaluate the performance of
business unit managers?
Critical Analysis and Discussion Questions
14-9.
lan27114_ch14_514-547.indd 531
A company prepares the master budget by taking each division manager’s estimate of revenues and costs for the coming period and entering the data into the budget without adjustment. At the end of the year, division managers are given a bonus if their actual division
profit exceeds the budgeted profit. Do you see any problems with this system?
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14-10. “If every division manager maximizes divisional income, we will maximize firm income.
Therefore, divisional income is the best performance measure.” Comment.
14-11. What problems might there be if the same methods used to compute firm income are used to
compute divisional income? Does your answer depend on the type of business a firm is in?
14-12. The chapter identified some problems with ROI-type measures and suggested that residual
income reduces some of them. Why do you think that ROI is a more common performance
measure in practice than residual income?
14-13. “Failure to invest in projects is not a problem when you use ROI. If there is a good project,
corporate headquarters will just tell the division manager to invest.” What are the difficulties with this view?
14-14. How would you respond to the following comment? “Residual income and economic value
added are identical.”
14-15. “I think that EVA is the best performance measure. I am going to recommend that we
evaluate all managers, of plants, divisions, subsidiaries, up to the chief executive officer
(CEO), using it.” Do you think this statement is appropriate? Explain.
14-16. Management of Division A is evaluated based on residual income measures. The division can
either rent or buy a certain asset. Might the performance evaluation technique have an impact
on the rent-or-buy decision? Why or why not? Will your answer change if EVA is used?
14-17. “Every one of our company’s divisions has a return on investment in excess of our cost of
capital. Our company must be a blockbuster.” Comment on this statement.
14-18. “Residual income solves some of the problems with ROI, but because it is an absolute number, it is difficult to compare divisions. We should use residual income divided by assets
and then we would have the best of both measures.” Do you agree with this statement?
Exercises
accounting
(L.O. 1)
14-19. Compute Divisional Income
Eastern Merchants shows the following information for its two divisions for year 1:
Revenue. . . . . . . . . . . . . . . . . . . . . . . .
Cost of sales . . . . . . . . . . . . . . . . . . . .
Allocated corporate overhead . . . . . . .
Other general and administration. . . . .
Eastern
Western
$1,200,000
769,500
72,000
158,500
$3,800,000
1,900,000
228,000
1,100,000
Required
Compute divisional operating income for the two divisions. Ignore taxes. How well have these
divisions performed?
(L.O. 1)
14-20. Compute Divisional Income
Refer to Exercise 14-19. The results for year 2 have just been posted:
Revenue. . . . . . . . . . . . . . . . . . . . . . . .
Cost of sales . . . . . . . . . . . . . . . . . . . .
Allocated corporate overhead . . . . . . .
Other general and administration. . . . .
Eastern
Western
$1,200,000
769,500
90,000
158,500
$2,800,000
1,400,000
210,000
1,100,000
Required
Compute divisional operating income for the two divisions. How well have these divisions performed?
(L.O. 2, 3)
S
lan27114_ch14_514-547.indd 532
14-21. Compute RI and ROI
TL Division of Giant Bank has assets of $14.4 billion. During the past year, the division had profits
of $1.8 billion. Giant Bank has a cost of capital of 8 percent. Ignore taxes.
Required
a. Compute the divisional ROI.
b. Compute the divisional RI.
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14-22. ROI versus RI
A division is considering the acquisition of a new asset that will cost $720,000 and have a cash
flow of $252,000 per year for each of the four years of its life. Depreciation is computed on a
straight-line basis with no salvage value. Ignore taxes.
533
(L.O. 2, 3)
Required
a. What is the ROI for each year of the asset’s life if the division uses beginning-of-year asset
balances and net book value for the computation?
b. What is the residual income each year if the cost of capital is 15 percent?
14-23. Compare Alternative Measures of Division Performance
The following data are available for two divisions of Solomons Company:
Division operating profit . . . . . .
Division investment . . . . . . . . .
North Division
South Division
$ 7,000,000
28,000,000
$ 39,000,000
260,000,000
(L.O. 2, 4)
The cost of capital for the company is 10 percent. Ignore taxes.
Required
a. If Solomons measures performance using ROI, which division had the better performance?
b. If Solomons measures performance using economic value added, which division had the better
performance? (The divisions have no current liabilities.)
c. Would your evaluation change if the company’s cost of capital were 20 percent?
14-24. Impact of New Asset on Performance Measures
Ocean Division currently earns $780,000 and has divisional assets of $3.9 million. The division
manager is considering the acquisition of a new asset that will add to profit. The investment has a
cost of $675,000 and will have a yearly cash flow of $168,000. The asset will be depreciated using
the straight-line method over a six-year life and is expected to have no salvage value. Divisional
performance is measured using ROI with beginning-of-year net book values in the denominator.
The company’s cost of capital is 15 percent. Ignore taxes.
(L.O. 2)
Required
a. What is the divisional ROI before acquisition of the new asset?
b. What is the divisional ROI in the first year after acquisition of the new asset?
14-25. Impact of Leasing on Performance Measures
Refer to the data in Exercise 14-24. The division manager learns that he has the option to lease the
asset on a year-to-year lease for $148,000 per year. All depreciation and other tax benefits would
accrue to the lessor. What is the divisional ROI if the asset is leased?
(L.O. 2)
14-26. Residual Income Measures and New Project Consideration
Refer to the information in Exercises 14-24 and 14-25.
(L.O. 3)
a.
b.
c.
What is the division’s residual income before considering the project?
What is the division’s residual income if the asset is purchased?
What is the division’s residual income if the asset is leased?
14-27. Impact of an Asset Disposal on Performance Measures
Noonan Division has total assets (net of accumulated depreciation) of $2,200,000 at the beginning of year 1. One of the assets is a machine that has a net book value of $200,000. Expected
divisional income in year 1 is $330,000 including $28,000 in income generated by the machine
(after depreciation). Noonan’s cost of capital is 12 percent. Noonan is considering disposing of
the asset today (the beginning of year 1).
(L.O. 2, 3)
Required
a. Noonan computes ROI using beginning-of-the-year net assets. What will the divisional ROI
be for year 1 assuming Noonan retains the asset?
b. What would divisional ROI be for year 1 assuming Noonan disposes of the asset for its book
value (there is no gain or loss on the sale)?
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c.
d.
(L.O. 2, 3)
Management Control Systems
Noonan computes residual income using beginning-of-the-year net assets. What will the divisional residual income be for year 1 assuming Noonan retains the asset?
What would divisional residual income be for year 1 assuming Noonan disposes of the asset
for its book value (there is no gain or loss on the sale)?
14-28. Impact of an Asset Disposal on Performance Measures
Refer to the facts in Exercise 14-27, but assume that Noonan has been leasing the machine for
$40,000 annually. Assume also that the machine generates income of $28,000 annually after the
lease payment. Noonan can cancel the lease on the machine without penalty at any time.
Required
a. Noonan computes ROI using beginning-of-the-year net assets. What will the divisional ROI
be for year 1 assuming Noonan retains the asset?
b. What would divisional ROI be for year 1 assuming Noonan disposes of the asset?
c. Noonan computes residual income using beginning-of-the-year net assets. What will the divisional residual income be for year 1 assuming Noonan retains the asset?
d. What would divisional residual income be for year 1 assuming Noonan disposes of the asset
for its book value (there is no gain or loss on the sale)?
(L.O. 2, 5)
S
14-29. Compare Historical Cost, Net Book Value to Gross Book Value
The Caribbean Division of Mega-Entertainment Corporation just started operations. It purchased depreciable assets costing $30 million and having a four-year expected life, after which
the assets can be salvaged for $6 million. In addition, the division has $30 million in assets
that are not depreciable. After four years, the division will have $30 million available from
these nondepreciable assets. This means that the division has invested $60 million in assets
with a salvage value of $36 million. Annual depreciation is $6 million. Annual operating cash
flows are $15 million. In computing ROI, this division uses end-of-year asset values in the
denominator. Depreciation is computed on a straight-line basis, recognizing the salvage values
noted. Ignore taxes.
Required
a. Compute ROI, using net book value for each year.
b. Compute ROI, using gross book value for each year.
(L.O. 2, 5)
S
(L.O. 2, 5)
S
14-30. Compare ROI Using Net Book and Gross Book Values
Refer to the data in Exercise 14-29. Assume that the division uses beginning-of-year asset values
in the denominator for computing ROI.
Required
a. Compute ROI, using net book value.
b. Compute ROI, using gross book value.
c. If you worked Exercise 14-29, compare those results with those in this exercise. How different
is the ROI computed using end-of-year asset values, as in Exercise 14-29, from the ROI using
beginning-of-year values in this exercise?
14-31. Compare Current Cost to Historical Cost
Refer to the information in Exercise 14-29. In computing ROI, this division uses end-of-year asset
values. Assume that all cash flows increase 10 percent at the end of each year. This has the following effect on the assets’ replacement cost and annual cash flows:
End of Year
1 ......
2 ......
3 ......
4 ......
.......
.......
lan27114_ch14_514-547.indd 534
Replacement Cost
Annual Cash Flow
$60,000,000 1.1 $66,000,000
$66,000,000 1.1 $72,600,000
Etc.
$15,000,000 1.1 $16,500,000
$16,500,000 1.1 $18,150,000
Etc.
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535
Depreciation is as follows:
Year
1.......
2.......
3.......
4.......
For the Year
“Accumulated”
$6,600,000
7,260,000
7,986,000
8,784,600
$ 6,600,000 ( 10% $66,000,000)
14,520,000 ( 20% 72,600,000)
23,958,000
35,138,400
Note that “accumulated” depreciation is 10 percent of the gross book value of depreciable assets
after one year, 20 percent after two years, and so forth.
Required
a. Compute ROI using historical cost, net book value.
b. Compute ROI using historical cost, gross book value.
c. Compute ROI using current cost, net book value.
d. Compute ROI using current cost, gross book value.
14-32. Effects of Current Cost on Performance Measurements
Upper Division of Lower Company acquired an asset with a cost of $600,000 and a four-year life.
The cash flows from the asset, considering the effects of inflation, were scheduled as follows:
Year
1. . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. . . . . . . . . . . . . . . . . . . . . . . . . . . .
(L.O. 2, 5)
Cash Flow
$225,000
255,000
285,000
300,000
The cost of the asset is expected to increase at a rate of 10 percent per year, compounded each year.
Performance measures are based on beginning-of-year gross book values for the investment base.
Ignore taxes.
Required
a. What is the ROI for each year of the asset’s life, using a historical cost approach?
b. What is the ROI for each year of the asset’s life if both the investment base and depreciation
are determined by the current cost of the asset at the start of each year?
Problems
accounting
14-33. Equipment Replacement and Performance Measures
Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech
products. Forbes Division, which has $4 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $5 million in automated equipment
for test machine assembly. The division’s expected income statement at the beginning of the
year was as follows:
lan27114_ch14_514-547.indd 535
Sales revenue . . . . . . . . . . . . . . . .
Operating costs
Variable . . . . . . . . . . . . . . . . . . . .
Fixed (all cash) . . . . . . . . . . . . . .
Depreciation
New equipment . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . .
$16,000,000
Division operating profit . . . . . . . . .
$ 3,750,000
(L.O. 2)
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2,000,000
7,500,000
1,500,000
1,250,000
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Management Control Systems
A sales representative from LSI Machine Company approached Oscar in October. LSI has for
$6.5 million a new assembly machine that offers significant improvements over the equipment Oscar
bought at the beginning of the year. The new equipment would expand division output by 10 percent
while reducing cash fixed costs by 5 percent. It would be depreciated for accounting purposes over
a three-year life. Depreciation would be net of the $500,000 salvage value of the new machine. The
new equipment meets Pitt’s 20 percent cost of capital criterion. If Oscar purchases the new machine,
it must be installed prior to the end of the year. For practical purposes, though, Oscar can ignore depreciation on the new machine because it will not go into operation until the start of the next year.
The old machine, which has no salvage value, must be disposed of to make room for the new
machine.
Pitt has a performance evaluation and bonus plan based on ROI. The return includes any losses
on disposal of equipment. Investment is computed based on the end-of-year balance of assets, net
book value. Ignore taxes.
Required
a. What is Forbes Division’s ROI if Oscar does not acquire the new machine?
b. What is Forbes Division’s ROI this year if Oscar acquires the new machine?
c. If Oscar acquires the new machine and it operates according to specifications, what ROI is
expected for next year?
(L.O. 2)
14-34. Evaluate Trade-Offs in Return Measurement
Oscar Clemente (Problem 14–33) is still assessing the problem of whether to acquire LSI’s assembly
machine. He learns that the new machine could be acquired next year, but if he waits until then, it will
cost 15 percent more. The salvage value would still be $500,000. Other costs or revenue estimates
would be apportioned on a month-by-month basis for the time each machine (either the current machine
or the machine Oscar is considering) is in use. Fractions of months may be ignored. Ignore taxes.
Required
a. When would Oscar want to purchase the new machine if he waits until next year?
b. What are the costs that must be considered in making this decision?
(L.O. 4)
14-35. Economic Value Added
Refer to the facts in Problem 14–33. Assume that Pitt’s performance measurement and bonus plans
are based on residual income instead of ROI. Pitt uses a cost of capital of 12 percent in computing
residual income.
Required
a. What is Forbes Division’s residual income if Oscar does not acquire the new machine?
b. What is Forbes Division’s residual income this year if Oscar acquires the new machine?
c. If Oscar acquires the new machine and operates it according to specifications, what residual
income is expected for next year?
(L.O. 2)
14-36. Evaluate Trade-Offs in Performance Measurement and Decisions
Refer to the facts in Problem 14–35. Assume that Pitt’s performance measurement and bonus plans
are based on residual income instead of ROI. Pitt uses a cost of capital of 12 percent in computing
residual income.
Required
a. When would Oscar want to purchase the new machine if he waits until next year?
b. What are the costs that must be considered in making this decision?
(L.O. 2)
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14-37. ROI and Management Behavior: Ethical Issues
Division managers at Asher Company are granted a wide range of decision authority. With the
exception of managing cash, which is done at corporate headquarters, divisions are responsible for
sales, pricing, production, costs of operations, and management of accounts receivable, inventories, accounts payable, and use of existing facilities.
If divisions require funds for investment, division executives present investment proposals to
corporate management, which analyzes and documents them. The final decision to commit funds
for investment purposes rests with corporate management.
The corporation evaluates divisional executive performance by using the ROI measure. The
asset base is composed of fixed assets employed plus working capital, exclusive of cash. The ROI
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537
performance of a division executive is the most important appraisal factor for salary changes. In
addition, each executive’s annual performance bonus is based on ROI results, with increases in ROI
having a significant impact on the amount of the bonus.
Asher adopted the ROI performance measure and related compensation procedures about
10 years ago and seems to have benefited from it. The ROI for the corporation as a whole increased
during the first years of the program. Although the ROI continued to increase in each division,
corporate ROI has declined in recent years. The corporation has accumulated a sizable amount of
short-term marketable securities in the past three years.
Corporate management is concerned about the increase in the short-term marketable securities. A recent article in a financial publication suggested that some companies have overemphasized the use of ROI, with results similar to those experienced by Asher.
Required
a. Describe the specific actions that division managers might have taken to cause the ROI to
increase in each division but decrease for the corporation. Illustrate your explanation with appropriate examples.
b. Using the concepts of goal congruence and motivation of division executives, explain how the
overemphasis on the use of the ROI measure at Asher Company might have resulted in the recent
decline in the company’s ROI and the increase in cash and short-term marketable securities.
c. What changes could be made in Asher Company’s compensation policy to avoid this problem?
Explain your answer.
d. Is it ethical for a manager to take actions that increase her ROI but decrease the firm’s ROI?
(CMA adapted)
14-38. Impact of Decisions to Capitalize or Expense on Performance Measurement:
Ethical Issues
Pharmaceutical firms, oil and gas companies, and other ventures inevitably incur costs on unsuccessful investments in new projects (e.g., new drugs or new wells). For oil and gas firms, a debate
continues over whether those costs should be written off as period expense or capitalized as part
of the full cost of finding profitable oil and gas ventures. For pharmaceutical firms, GAAP in the
United States is clear that R&D costs are to be expensed when incurred.
Pharm-It has been writing R&D costs off to expense as incurred for both financial reporting
and internal performance measurement. However, this year a new management team was hired to
improve the profit of Pharm-It’s Cardiology Division. The new management team was hired with
the provision that it would receive a bonus equal to 10 percent of any profits in excess of baseyear profits of the division. However, no bonus would be paid if profits were less than 20 percent
of end-of-year investment. The following information was included in the performance report for
the division:
a
This Year
Base Year
Sales revenues . . . . . . . . . . . . . . . . . . . . .
Costs incurred
R&D Expense . . . . . . . . . . . . . . . . . . . .
Depreciation and other amortization . . .
Other costs . . . . . . . . . . . . . . . . . . . . . .
$ 20,500,000
$20,000,000
-03,900,000
8,000,000
4,000,000
3,750,000
7,750,000
Division profit . . . . . . . . . . . . . . . . . . . . . .
$
8,600,000
$ 4,500,000
End-of-year investment. . . . . . . . . . . . . . .
$40,500,000
a
(L.O. 1, 2)
mhhe.com/lanen3e
Increase over
Base Year
$4,100,000
$34,500,000
Includes other investments not at issue here.
During the year, the new team spent $5 million on R&D activities, of which $4,500,000 was
for unsuccessful ventures. The new management team has included the $4,500,000 in the current
end-of-year investment base because “You can’t invent successful drugs without missing on a few
unsuccessful ones.”
Required
a. What is the ROI for the base year and the current year? Ignore taxes.
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b.
c.
(L.O. 1)
Management Control Systems
What is the amount of the bonus that the new management team is likely to claim? Is this ethical?
If you were on Pharm-It’s board of directors, how would you respond to the new management’s claim for the bonus?
14-39. Evaluate Performance Evaluation System: Behavioral Issues
Several years ago, Seville Company acquired Salvador Components. Prior to the acquisition, Salvador manufactured and sold automotive components products to third-party customers. Since
becoming a division of Seville, Salvador has manufactured components only for products made by
Seville’s Luxo Division.
Seville’s corporate management gives the Salvador Division management considerable latitude in running the division’s operations. However, corporate management retains authority for
decisions regarding capital investments, product pricing, and production quantities.
Seville has a formal performance evaluation program for all division managements. The
evaluation program relies substantially on each division’s ROI. Salvador Division’s income statement provides the basis for the evaluation of Salvador’s management. (See the following income
statement.)
The corporate accounting staff prepares the divisional financial statements. Corporate general
services costs are allocated on the basis of sales dollars, and the computer department’s actual costs
are apportioned among the divisions on the basis of use. The net divisional investment includes
divisional fixed assets at net book value (cost less depreciation), divisional inventory, and corporate
working capital apportioned to the divisions on the basis of sales dollars.
SEVILLE COMPANY
Salvador Division
Income Statement
For the Year Ended October 31
($000)
Sales revenue . . . . . . . . . . . . . . . . . . . . . .
Costs and expenses
Product costs
Direct materials . . . . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . .
Factory overhead . . . . . . . . . . . . . . . . . .
$ 4,000
8,800
10,400
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less increase in inventory . . . . . . . . . . . . .
$23,200
2,800
Engineering and research . . . . . . . . . . . . .
Shipping and receiving . . . . . . . . . . . . . . . .
Division administration
Manager’s office . . . . . . . . . . . . . . . . . . .
Cost accounting . . . . . . . . . . . . . . . . . . .
Personnel . . . . . . . . . . . . . . . . . . . . . . . .
Corporate cost
General services . . . . . . . . . . . . . . . . . .
Computer . . . . . . . . . . . . . . . . . . . . . . . .
Total costs and expenses . . . . . . . . . . . . . .
Divisional operating profit . . . . . . . . . . . .
Net plant investment . . . . . . . . . . . . . . . . . .
Return on investment . . . . . . . . . . . . . . . . .
$32,000
$20,400
960
1,920
$1,680
320
656
$1,840
384
2,656
2,224
$28,160
$ 3,840
$12,800
30%
Required
a. Discuss Seville Company’s financial reporting and performance evaluation program as it
relates to the responsibilities of Salvador Division.
b. Based on your response to requirement (a), recommend appropriate revisions of the financial
information and reports used to evaluate the performance of Salvador’s divisional management. If revisions are not necessary, explain why.
(CMA adapted)
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14-40. ROI, EVA, and Different Asset Bases
House Station, Inc., is a nationwide hardware and furnishings chain. The manager of the House
Station Store in Portland is evaluated using ROI. House Station headquarters requires an ROI of 10
percent of assets. For the coming year, the manager estimates revenues will be $2,340,000, cost of
goods sold will be $1,467,000, and operating expenses for this level of sales will be $234,000. Investment in the store assets throughout the year is $1,687,500 before considering the following proposal.
A representative of Sharp’s Appliances approached the manager about carrying Sharp’s line
of appliances. This line is expected to generate $675,000 in sales in the coming year at the
Portland House Station store with a merchandise cost of $513,000. Annual operating expenses
for this additional merchandise line total $76,500. To carry the line of goods, an inventory investment of $495,000 throughout the year is required. Sharp’s is willing to floor plan the merchandise so that the House Station store will not have to invest in any inventory. The cost of
floor planning would be $60,750 per year. House Station’s marginal cost of capital is 10 percent.
Ignore taxes.
539
(L.O. 1, 2, 4)
mhhe.com/lanen3e
Required
a. What is the Portland House Station store’s expected ROI for the coming year if it does not
carry Sharp’s appliances?
b. What is the store’s expected ROI if the manager invests in Sharp’s inventory and carries the
appliance line?
c. What would the store’s expected ROI be if the manager elected to take the floor plan option?
d. Would the manager prefer (a), (b), or (c)? Why?
e. Would your answers to any of the above change if EVA was used to evaluate performance? For
purposes of this problem, assume no current liabilities.
14-41. Economic Value Added
Suwon Pharmaceuticals invests heavily in research and development (R&D), although it must currently treat its R&D expenditures as expenses for financial accounting purposes. To encourage
investment in R&D, Suwon evaluates its division managers using EVA. The company adjusts accounting income for R&D expenditures by assuming these expenditures create assets with a twoyear life. That is, the R&D expenditures are capitalized and then amortized over two years.
BK division of Suwon shows after-tax income of $2.5 million for year 2. R&D expenditures
in year 1 amounted to $1 million and in year 2, R&D expenditures were $1.6 million. For purposes
of computing EVA, Suwon assumes all R&D expenditures are made at the beginning of the year.
Before adjusting for R&D, BK division shows assets of $10 million at the beginning of year 2 and
current liabilities of $200,000. Suwon computes EVA using divisional investment at the beginning
of the year and a 12 percent cost of capital.
(L.O. 4)
Required
Compute EVA for BK division for year 2.
14-42. Economic Value Added
Biddle Company uses EVA to evaluate the performance of division managers. For the Wallace
Division, after-tax divisional income was $400,000 in year 3.
The company adjusts the after-tax income for advertising expenses. First, it adds the annual
advertising expenses back to after-tax divisional income. Second, the company managers believe
that advertising has a three-year positive effect on the sale of the company’s products, so it amortizes advertising over three years. Advertising expenses in year 1 will be expensed 50 percent,
40 percent in year 2, and 10 percent in year 3. Advertising expenses in year 2 will be expensed
50 percent, 40 percent in year 3, and 10 percent in year 4. Advertising expenses in year 3 will be
amortized 50 percent, 40 percent in year 4, and 10 percent in year 5. Third, unamortized advertising
expenses become part of the divisional investment in the EVA calculations. Wallace Division had
incurred advertising expenses of $100,000 in year 1 and $200,000 in year 2. It incurred $240,000 of
advertising in year 3.
Before considering the unamortized advertising, the Wallace Division had total assets
of $4,200,000 and current liabilities of $600,000 at the beginning of year 3. Biddle Company
calculates EVA using the divisional investment at the beginning of the year. The company uses a
10 percent cost of capital to compute EVA.
(L.O. 4)
Required
Compute the EVA for the Wallace Division for year 3. Is the division adding value to shareholders?
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Integrative Cases
(L.O. 1, 2, 3, 4)
14-43. Barrows Consumer Products (A)
I thought evaluating performance would be easier than this. I have three vice presidents, operating the same business in three different countries. I need to be able
to compare them in order to prepare compensation recommendations to the board.
The problem is that there are so many variables that each of the managers can
make some claim to having the best performance. I hope our consultant can help
me sort this out.
Alice Karlson, Executive Vice President
Southeast Asia Emerging Markets Sector
Barrows Consumer Products
Organization
Barrows Consumer Products is a large, multinational consumer products firm based in the
United States. In the mid-1990s, Barrows made a strategic decision to enter the transitional and emerging markets. Each of the new markets was led by an executive vice president and organized along country lines. Barrows believed this form of organization made it
easier to evaluate each country and also made it easier to exit from a country it identified as
unprofitable.
One of the new markets developed by Barrows was Southeast Asia. Although there
was significant competition in the region from other Asian and European competitors, the
management of Barrows believed its advantage was in its portfolio of products with widely
recognized brand names. Barrows chose three countries to enter initially: Indonesia, the
Philippines, and Vietnam. At the time of the decision, all three appeared to represent significant growth opportunities.
Barrows’s policy in these new markets was to install a Barrows manager originally from
the country who was willing to return and manage the business. Barrows believed that this
policy resulted in additional goodwill and also allowed the managers to use their knowledge
of local business customs. (It also hoped to take advantage of any personal ties the managers
might have in business and government, but this was not included in its policy statement.) A
simplified organization chart for the Southeast Asia Emerging Markets Sector is provided in
Exhibit 14.12.
Although all three countries could be classified as emerging or transitional economies,
there are considerable differences among them. Indonesia has a very large population, while the
Philippines and Vietnam are smaller. The Philippines, however, has a higher level of per capita
income; Vietnam is the poorest of the three countries. Selected demographic data for the three
countries are shown in Exhibit 14.13.
Exhibit 14.12
Organization Chart,
Southeast Asia Emerging
Markets Sector—Barrows
Consumer Products
Barrows Consumer Products
Alice Karlson
Executive Vice President
Southeast Asia Emerging Markets
Ade Darmadi
Vice President
Indonesia
lan27114_ch14_514-547.indd 540
Isadore Real
Vice President
Philippines
Binh Tran
Vice President
Vietnam
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Chapter 14
Business Unit Performance Measurement
Indonesia
Population (millions—approximate) . . .
GDP per capita (in U.S. dollars) . . . . . .
225
$2,830
The Philippines
Vietnam
80
$3,500
80
$1,700
541
Exhibit 14.13
Selected Demographic
Data, Southeast Asia
Emerging Markets Sector
Performance Evaluation
Barrows has a well-developed set of performance measures that is used for managerial evaluation. The two primary measures that are used for groups in the United States, Canada, Western
Europe, and Japan are division (or country) profit and return on investment (ROI). Return
on investment is computed by dividing division (or country) operating income (essentially,
income before taxes) by division (or country) total assets. While profit and ROI are commonly
used in much of the company, the executive vice presidents in emerging market sectors are
given considerable leeway in evaluating their individual country vice presidents. This performance evaluation is important to these managers. Compensation in the Southeast Asia Sector
consists of salary and bonus. The bonus pool for the three managers is dictated by corporate
headquarters of Barrows in the United States. The bonus pool formula is not explicitly defined
although there is a clear correlation between the size of the pool and the profitability of the
sector, however measured.
The allocation of the pool to the individual country managers is at the discretion of Ms.
Karlson, the sector executive vice president. In March of year 9, the financial results from
the three countries for year 8 have been tabulated and she is now evaluating them. Because
this is her first year in this position, she has not had to perform this task in the past. She has
hired a local compensation consultant to advise her on the relative performance of the three
managers.
The financial staff at sector headquarters receives the financial statements from the controller’s staff in each of the three countries and ensures that the statements are consistently prepared
in a common currency. The income statements for year 8 are shown in Exhibit 14.14. The balance
sheets as of the beginning of year 8 are shown in Exhibit 14.15. Ms. Karlson discusses the source
of her concern.
When I look at the financial statements, I can see immediately that Ade [Darmadi,
V.P.—Indonesia] has outperformed Isadore [Real, V.P.—Philippines]. But Indonesia
is a much larger market than the Philippines. So I calculate ROI to try and adjust
for size and now Isadore is outperforming Ade. When I mention this to Ade, she
counters that although Indonesia is larger, it is also poorer and geographically
dispersed, leading to higher distribution costs. The only thing I can say for sure is
that Binh has not developed much of a market.
I also wonder whether headquarters is looking at the right performance
measure. I recently attended a seminar on new performance evaluation measures and the seminar speaker spent quite a bit of time on something called
Exhibit 14.14
Income Statement
For Year 8
($000)
Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of sales . . . . . . . . . . . . . . . . . . . . . . .
Allocated corporate overhead . . . . . . . . . .
Local advertising . . . . . . . . . . . . . . . . . . . .
Other general and administration. . . . . . . .
Operating income. . . . . . . . . . . . . . . . . . . .
Tax expense . . . . . . . . . . . . . . . . . . . . . . . .
Net Income . . . . . . . . . . . . . . . . . . . . . . .
lan27114_ch14_514-547.indd 541
Indonesia
The Philippines
Vietnam
$18,000
8,650
432
5,100
868
$ 2,950
885
$ 2,065
$9,500
4,200
228
2,955
437
$1,680
504
$1,176
$2,500
1,100
60
960
350
$ 30
9
$ 21
Country-Level Income
Statements, Emerging
Markets Sector—Barrows
Consumer Products
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542
Part IV
Management Control Systems
Exhibit 14.15 Country-Level Balance Sheets, Emerging Markets Sector—Barrows Consumer Products
Balance Sheet as of January 1
($000)
Indonesia
__________________
Year 8
Year 9
The Philippines
__________________
Year 8
Year 9
Vietnam
__________________
Year 8
Year 9
Assets
Cash. . . . . . . . . . . . . . . . . . . . . . . .
Accounts rec. . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . .
Plant assets (net) . . . . . . . . . . . . . .
$ 750
1,600
1,350
$3,700
3,500
$ 900
1,800
1,300
$4,000
3,400
$ 500
450
500
$1,450
2,550
$ 510
600
900
$2,010
2,402
$ 320
500
320
$1,140
740
$ 300
640
490
$1,430
810
Total Assets . . . . . . . . . . . . . . . .
$7,200
$7,400
$4,000
$4,412
$1,880
$2,240
Liabilities and equities
Accounts payable. . . . . . . . . . . . . .
Other current liabilities . . . . . . . . . .
$ 575
680
$ 620
720
$ 250
454
$ 315
450
$ 190
560
$ 380
709
Total current liabilities . . . . . . . . .
Long-term debt. . . . . . . . . . . . . . . .
$1,255
-0-
$1,340
-0-
$ 704
-0-
$ 765
-0-
$ 750
-0-
$1,089
-0-
Total liabilities . . . . . . . . . . . . . . .
$1,255
$1,340
$ 704
$ 765
$ 750
$1,089
Common stock . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . .
745
5,200
745
5,315
496
2,800
496
3,151
450
680
450
701
Total shareholders’ equity . . . . . . .
Total liabilities and equities . . . . .
$5,945
$7,200
$6,060
$7,400
$3,296
$4,000
$3,647
$4,412
$1,130
$1,880
$1,151
$2,240
economic value added (EVA). The way I understand it, EVA adjusts profit
and subtracts a capital charge from it. The capital charge is the cost of capital
multiplied by the net assets (total assets less current liabilities) employed.
I guess I would use the cost of capital of 20 percent after-tax that corporate
policy requires I use for investment decisions. The problem I have is I am not
sure how to adjust income, which is an accounting measure, into something
more meaningful. We don’t do any R&D here, so the only item on the statements that was mentioned at the seminar is advertising. (Note: Advertising
expenses for the previous three years are shown in Exhibit 14.16.) When I
was working in the United States, I came across a study stating that advertising expenditures in our industry have an expected life of about three years.
If that’s true, then clearly the way we account for advertising is wrong and
I should adjust these results accordingly.
There are other issues that I think are more ambiguous. For one thing, Binh
developed a new approach for delivering products that cut distribution costs in
Vietnam. At our annual retreat, he shared his ideas with Ade and Isadore about
how they could adapt this to their markets. In addition, many customers want their
stores in Vietnam and Indonesia to be entirely served from Indonesia, so Binh
receives no credit for that business.
Exhibit 14.16
Historical Advertising
Expenses, Emerging
Markets Sector—Barrows
Consumer Products
lan27114_ch14_514-547.indd 542
Year
Year 7 . . . . . . . . . . . .
Year 6 . . . . . . . . . . . .
Year 5 . . . . . . . . . . . .
Indonesia
Philippines
Vietnam
Total
$5,100
4,200
4,500
$2,502
2,400
2,700
$600
549
570
$8,202
7,149
7,770
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Chapter 14
Business Unit Performance Measurement
543
Required
a. What are some of the factors causing the problems in measuring performance in the Southeast
Asia Sector?
b. Rank the three countries using each of the following measures of performance:
1. Country profit.
2. Return on investment.
3. Economic value added (EVA).
c. Are there other performance measures you would suggest? How would you measure these?
d. Write a one-page memo to Ms. Karlson explaining which country performed best. Be sure to
explain your reasoning.
(© Copyright William N. Lanen, 2010)
14-44. Capital Investment Analysis and Decentralized Performance Measurement
The following exchange occurred just after the finance staff at Diversified Electronics rejected a
capital investment proposal.
(L.O. 2, 3, 4)
David Parker (Product Development): I just don’t understand why you rejected my proposal. We
can expect to make $230,000 on it before tax.
Shannon West (Finance): David, get real. This product proposal does not meet our short-term
ROI target of 15 percent after tax.
David: I’m not so sure about the ROI target, but it is profitable—$230,000 worth.
Shannon: We believe that a company like Diversified Electronics should have a return on
investment of 15 percent after tax. The Professional Services division consistently comes
in with a 15 percent or better ROI, while your division, Residential Products, has managed to get only 10 percent. The performance of the Aerospace Products division has been
especially dismal, with an ROI of only 6 percent. We expect divisions in the future to
carry their share of the load.
Diversified Electronics, a growing company in the electronics industry, had grown to its present size of more than $140 million in sales. (See Exhibits 14.17 and 14.18 for Diversified’s year 1
and year 2 income statements and balance sheets, respectively.) Diversified Electronics has three
divisions, Residential Products, Aerospace Products, and Professional Services, each of which accounts for about one-third of Diversified Electronics’s sales. Residential Products, the oldest division, produces furnace thermostats and similar products. The Aerospace Products division is a
large job shop that builds electronic devices to customer specifications. A typical job or batch takes
several months to complete. About one-half of Aerospace Products’s sales are to the U.S. Defense
Department. The newest of the three divisions, Professional Services, provides consulting engineering services. This division has grown tremendously since Diversified Electronics acquired it
seven years ago.
DIVERSIFIED ELECTRONICS
Income Statements for Year 1 and Year 2
(all dollar amounts in thousands, except earnings-per-share figures)
Year Ended December 31
lan27114_ch14_514-547.indd 543
Year 1
Year 2
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . .
$141,462
108,118
$148,220
113,115
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and general . . . . . . . . . . . . . . . . . . . . . . . .
$ 33,344
13,014
$ 35,105
13,692
Profit before taxes and interest . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 20,330
1,190
$ 21,413
1,952
Profit before taxes . . . . . . . . . . . . . . . . . . . . . . . . .
Income tax expense . . . . . . . . . . . . . . . . . . . . . . .
$ 19,140
7,886
$ 19,461
7,454
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 11,254
$ 12,007
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . .
$5.63
$6.00
Exhibit 14.17
Income Statements—
Diversified Electronics
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544
Exhibit 14.18
Balance Sheets—
Diversified Electronics
Part IV
Management Control Systems
DIVERSIFIED ELECTRONICS
Balance Sheets for Year 1 and Year 2
(all dollar amounts in thousands)
Year Ended December 31
December 31
_____________________
Year 1
Year 2
Assets
Cash and temporary investments . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$
1,404
13,688
42,162
$ 57,254
$
Plant and equipment:
Original cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . .
Net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investments and other assets . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
107,326
42,691
$ 64,635
3,143
$125,032
115,736
45,979
$ 69,757
3,119
$135,419
Liabilities and owners’ equity
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current portion of long-term debt . . . . . . . . . . . . . . . . . . .
$ 10,720
1,210
–0–
$ 12,286
1,045
1,634
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total owners’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 11,930
559
12,622
$ 25,111
47,368
52,553
$ 99,921
$ 14,965
985
15,448
$ 31,398
47,368
56,653
$104,021
Total liabilities and owners’ equity . . . . . . . . . . . . . . . . . . .
$125,032
$135,419
1,469
15,607
45,467
$ 62,543
Each division operates independently of the others, and corporate management treats each as a
separate entity. Division managers make many of the operating decisions. Corporate management
coordinates the activities of the various divisions, including the review of all investment proposals
over $400,000.
Diversified Electronics measures return on investment as the division’s net income divided
by total assets. Each division’s expenses include the allocated portion of corporate administrative
expenses. Since each of Diversified Electronics’s divisions is located in a separate facility, management can easily attribute most assets, including receivables, to specific divisions. Management allocates the corporate office assets, including the centrally controlled cash account, to the divisions
on the basis of divisional revenues.
Exhibit 14.19 shows the details of David Parker’s rejected product proposal.
Required
a. Was the decision to reject the new product proposal the right one? If top management
used the discounted cash flow (DCF) method instead, what would the results be? The
company uses a 15 percent after-tax cost of capital (i.e., discount rate) in evaluating projects such as these.
b. Evaluate the manner in which Diversified Electronics has implemented the investment
center concept. What pitfalls did it apparently not anticipate? What, if anything, should
be done with regard to the investment center approach and the use of ROI as a measure of
performance?
c. What conflicting incentives for managers can occur when yearly ROI is used as a performance
measure and DCF is used for capital budgeting?
(© Copyright Michael W. Maher, 2010)
lan27114_ch14_514-547.indd 544
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Chapter 14
Business Unit Performance Measurement
Exhibit 14.19
DIVERSIFIED ELECTRONICS
Financial Data for New Product Proposal
1. Projected asset investment:
Land purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plant and equipmenta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
545
Data—New Product
Proposal
$ 200,000
800,000
$1,000,000
2. Cost data, before taxes (first year):
Variable cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Differential fixed cost b . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3.00
$170,000
3. Price/market estimate (first year):
Unit price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$7.00
100,000 units
4. Taxes: The company assumes a 40 percent tax rate for income and gains on land
sale. Depreciation of plant and equipment according to tax law is as follows: year 1:
20 percent; year 2: 32 percent; year 3: 19 percent; year 4: 14.5 percent; and year
5: 14.5 percent. Taxes are paid for taxable income in year 1 at the end of year 1;
taxes are paid for taxable income in year 2 at the end of year 2, and so on.
5. The new product is in a growth market with expected price increases of 10 percent
per year. This 10 percent applies to revenues and costs except depreciation and land for
years 2 through 8 (i.e., year 2 amounts will reflect a 10 percent increase over the year 1
amounts shown in the data above).
6. The project has an eight-year life. Land will be sold for $400,000 at the end of
year 8.
7. Assume the gain on the sale of land is taxable at the 40 percent rate.
Annual capacity of 120,000 units.
Includes straight-line depreciation on new plant and equipment, depreciated for eight years with no net
salvage value at the end of eight years.
a
b
Solutions to Self-Study Questions
1.
a. Divisional income.
HOME FURNISHINGS, INC.
Divisional Income
For Year 2
($000)
lan27114_ch14_514-547.indd 545
Kitchen
Bath
Total
Revenue . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of sales . . . . . . . . . . . . . . . . . . . . . .
Gross margin. . . . . . . . . . . . . . . . . . . .
Allocated corporate overhead . . . . . . . . .
Local advertising . . . . . . . . . . . . . . . . . . .
Other general and administrative . . . . . .
Operating income . . . . . . . . . . . . . . . . . .
Taxes (@ 35%) . . . . . . . . . . . . . . . . . . . .
$10,000
5,400
$ 4,600
460
2,000
500
$ 1,640
574
$5,000
3,000
$2,000
200
500
260
$1,040
364
$15,000
8,400
$ 6,600
660
2,500
760
$ 2,680
938
After-tax income . . . . . . . . . . . . . . . . . . .
$ 1,066
$ 676
$ 1,742
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546
Part IV
2.
Management Control Systems
Kitchen has higher accounting income, but the two divisions are of different sizes.
The gross margin ratio for Kitchen is 46 percent ( $4,600 $10,000) and for Bath
it is 40 percent ( $2,000 $5,000). These results suggest that the performance of
the manager of Kitchen Products was better than that of the manager of Bath Products. The operating margin ratio of Kitchen Products was 16.4 percent ( $1,640 $10,000), and the operating margin of Bath Products was 20.8 percent ( $1,040 $5,000). The profit margin ratio for Kitchen Products was 10.7 percent ( $1,066 $10,000) and for Bath Products it was 13.5 percent ( $676 $5,000). Based on the
operating margin ratio and the profit margin, the performance of the Bath Products
manager was better.
b. From these results, we can see that the Kitchen Products manager appears to have
earned higher margins on what was sold (higher gross margin ratio) while the Bath
Products manager appears to have operated the division more efficiently (higher operating margin ratio). These comparisons are difficult because the managers operate in
different markets.
a. Return on investment (ROI) is after-tax income (computed in the solution to Self-Study
Question 1) divided by divisional assets (given in Question 2).
Kitchen
Bath
($000)
After-tax income . . . . . . . . . . .
Divisional investment . . . . . . .
ROI
3.
lan27114_ch14_514-547.indd 546
$1,066
8,200
$1,066
______
13%
$8,200
$
676
4,000
$676
______
17%
$4,000
b. Based on the cost of the assets employed in the two divisions, the manager of Bath Products reported better performance, based on ROI.
In the case of the display racks, the analysis of residual income is the same as that of
EVA. There are no issues of amortizing the investment because the investment in display
racks is already being depreciated. Therefore, neither manager has an incentive, at least
based on the results in the first year of the investment, to invest in the display racks. (See
Exhibit 14.8.)
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Chapter 14
4.
Business Unit Performance Measurement
547
(The following computations are in thousands.)
Net Book Valuea
Year
1
2
3
a. Historical Cost
b. Current Cost
$1,000 (.1 $5,000)
ROI ____________________
$5,000 (.1 $5,000)
$1,000 (.1 $4,000)
ROI ___________________
$4,000 (.1 $4,000)
$600
______
$800
______
$3,600
$1,200 (.1 $4,000)
ROI ___________________
$4,000 (.2 $4,000)
ROI 16.7%
25%
$3,200
$1,420 (.1 $4,000)
___________________
$4,000 (.3 $4,000)
$1,020
______
$2,800
36.4%
$500
______
11.1%
$575
______
11.5%
$640
______
11.7%
$4,500
$1,200 (.1 $6,250)
ROI ___________________
$6,250 (.2 $6,250)
$5,000
$1,420 (.1 $7,800)
ROI ___________________
$7,800 (.3 $7,800)
$5,460
Gross Book Valueb
c. Historical Cost
d. Current Cost
1
ROI $600
______
15%
ROI $500
______
10%
2
ROI $800
______
20%
ROI $575
______
9.2%
3
ROI $1,020
______
25.5%
ROI $640
______
8.2%
$4,000
$4,000
$4,000
$5,000
$6,250
$7,800
a
The first term in the numerator is the annual cash flow. The second term is the annual depreciation.
The first term in the denominator is the gross book value of the assets before accumulated
depreciation. The second term is the accumulated depreciation. The denominator is the original (or the
replacement) cost of the asset less accumulated depreciation. Accumulated depreciation is 10 percent
of the gross book value after one year, 20 percent after two years, and 30 percent after three years.
The numerator is the adjusted (historical or current cost) annual net income. The denominator is the
gross book value of the assets.
b
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